The End of the World?

No, my friends, I am not writing about the Supreme Court. I am not even writing about Donald Trump. I am writing in response to months, if not years, of hand-wringing by some of my friends about various unfolding trends that promise something akin to the end of the world.

Artificial intelligence (AI), productivity, globalization, and the demise of baby boomers are among trends that cause all sorts of consternation if not hyperventilation. I won’t argue that these trends won't disturb our happy society. I won’t even argue that they are not already affecting many people in many places.

Concern for these and other issues is legitimate. What I am saying today is that, while there is much truth to the fact that we have considerable challenges ahead, the end of the world is nowhere in sight. Our biggest challenge is to decide as a nation what we can do so that jobs continue to exist and people are paid enough to keep the economy growing. This is our biggest challenge because it will take thoughtful policy in a very complicated US and global economy. There will always be more than one way to resolve these issues. In a world where politicians would rather spit that compromise, it is hard to see how they can be trusted to do the right thing. Whatever they could do won’t be perfect but sadly it is not clear that they are capable of anything besides giving hateful interviews to greedy media organizations.

But we do have time and it is possible that sanity might return to the political arena. Maybe it will take a severe recession or a flood of Biblical proportions, but there is at least some hope. In the meantime, I suggest we look at some data to reassure ourselves that the end of the world has not already come.

On the first line of the table below are numbers for the productivity of the private non-farm business sector. These are index numbers representing productivity in 2006 and 2018, and then the percentage change in the index over those 13 years. Notice that productivity in the business sector rose by around 15%.

The second line has comparable numbers for employment. The employment numbers are for all employees of non-farm businesses. They are in millions. In 2006, we had 137 million employees in the US. That number took a big dip in the recession down to 130 million in 2010 but then reached 148 million in early 2018. That amounted to an 8.5% increase.

The final row is the employment cost index. This index measures changes in wages and benefits of private industry workers. Starting at an index value of 102.1 in 2006, wages and benefits rose to almost 133 by 2018. That’s an increase of 30 percent.

The upshot of this little table is that we are nowhere near falling off the earth. While these numbers were clearly affected in a negative way by a very scary recession, they show that productivity grew, employment grew, and the wages and benefits of workers increased even faster.

I purposely leave you with this impression of growth. I could have compared this time to previous ones. I could have compared the wages and benefits change to inflation. I could have dissected the employment numbers by manufacturing versus services. There is a lot more I could have done to put changes from 2006 to 2018 in a more complete perspective. But I save that for other posts and other purposes.

I am not trying to say that this is the rosiest of times. I am not trying to say that we don’t need to get to work on solutions. But what I have tried to do with this little table is to suggest that we stop panicking. This is not the worst of all possible worlds. I am no Pangloss but then, again I am no Martin either (characters in Voltaire’s Candide). Pessimism might be warranted by some things we see today – but pessimism surely will not provide the answers. This glass is definitely half-full. How can we get policymakers to work together for us -- to make the glass even more half-full?

2006         2018       %Change

Productivity            94.4        108.2          14.6

Employment         136.5        148.1             8.5

Wages & Benefits 102.1        132.5           29.8

Note: The values are for the first quarters of these years.

Unit Labor Costs

One of the creepy things about learning economics is all the technical jargon. Diminishing marginal utility, gross private domestic investment, and the production possibilities frontier are good examples. What the hell are these things? That can be the subject of another post because today I want to focus on another term economists throw around like salmon at the Seattle Fish Market.

Today I want to discuss unit labor costs. Say that 30 times and I promise you and all those within 50 feet of you the best sleep you have had in months. It's better than a My Pillow. To make sure I don’t lose you, let’s rename it ULC. ULC rhymes with sulk but that has no consequence here. 

ULC could be the most important macroeconomic variable in town this year. So you should know her. If you saw ULC sitting alone at the end of a bar, you would ordinarily tip toe quietly in the other direction. But this year, ULC is the Queen of the Ball.

That’s quite a claim. Yet I don’t hear anyone talking about her. Before I am done with you today, I want to convince you that ULC is at the heart of many issues we discuss today – rising wages, rising prices, the next recession, and of course, the size of our new tariffs on Armagnac.

Imagine any product – let’s think about a bottle of JD. Most of the cost of producing one more bottle of JD is what you pay the employees to produce it. This includes their wages and any other earnings they might receive in the way of benefits. Logic suggests that, if everything else is the same, a rise in labor costs means the company will have to charge more for a bottle of JD. If it used to cost $10 to produce another bottle of JD and now it costs $12, then one would expect the price to reflect that cost increase. 

The labor representative will interrupt us now and point to the fact that the extra wage won't lead to a price increase because the JD workers were more productive this year. The price of a bottle of JD depends on the labor cost and the labor productivity.

For example, suppose wages go up 5% this year. Don’t we have to charge more for a bottle of Jack? Nope – it depends on how productive labor was. Suppose workers got really jacked up this year and produced 10% more bottles of Jack. That is, you got 10% more Jack for 5% more money. In that example the cost of labor in each bottle of Jack was lower! Thus they can sell the Jack at a lower price.

ULC is, therefore, a delicious macro concept that summarizes the key factors impacting the cost of goods and service:

• ULC went up – cost per unit is higher and therefore we ought to raise price (or take lower profits)  
• ULC went down – cost per unit is lower and therefore we can lower price and be more competitive (or keep prices the same and take higher profits)
• ULC did not change – cost per unit is the same. Go fishing.

So you can see that ULC is a vital part of the economy and yet most of you thought it meant Underware Latex Creep.  

Here is the most fun part. The graph at the bottom of this life-saving exercise shows you the history of changes in ULC since before Joe Biden was born. I won’t bore you millennials with all that history stuff but you can see that before 1980, ULC was quite the party animal. It was all over the place – rising by almost 13% in 1974 not long after a mere blip of 1% a few years before. Imagine if you were selling Kool-Aid in the front yard and the cost of getting your mom to make the Kool-Aid for you rose by 13% one year. If you passed that cost increase on to your customers, they might decide to go down the road to Peter's house.

Notice that since 1980, ULC became more well-behaved. It has its cycles but they are much less pronounced. The mean change of costs per unit is about 2.5%. Notice also that just about every recession —the grey bars – was preceded by a rising trend in ULC. Clearly, when costs per unit are on the rise the resulting higher prices of goods and services seems juicy – but if this keeps up the economy can no longer handle it.

This brings us to the present. The average change in ULC is remarkably less than 2.5%, and there is no discernible upward trend. After it dropped into negative territory recently, it jumped back to positive territory but there is no clear upward trend. In fact, if you look at behavior since around 2011, you might see a downward trend.

If it ordinarily takes a few years of rising ULC to cause a recession, there is little in this graph to suggest an imminent recession or slowdown in the economy. But aren’t wages beginning to rise faster? Won’t that make ULC jump and signal bad times ahead? Yes, wages might rise but remember ULC is impacted by productivity changes as well. If productivity changes as much or more than ULC – then ULC won’t change at all.

So fasten your seatbelts, kids. This is a race between wage growth and productivity. Which one are you betting on for the next few years?

Trickle-Up Economics and Labor Infrastructure

When both parties agree then you know something is wrong. Infrastructure spending (IS) has gained a lot of bipartisan support lately. There is a lot of pressure on Trump and Congress to put together a really big package on infrastructure. What does that mean and is that the best we can do with our money?

The usual support for more IS focuses on simple theories. Paramount is that IS is part of the production and delivery process of goods and services. An improvement in infrastructure will accordingly increase our lagging national productivity. When workers are more productive the nation becomes more competitive.  A second logic is that building more infrastructure takes workers and therefore employment will increase. Third, when those workers have more income they will buy more goods and services thus providing more business and employment for other firms and workers. Can you hear the horns blowing? Who could be against more IS?

The reason people can be against more IS is that the above is simple theory. Put all this into the context of 2017. For any of the above magic to transpire we have to have viable projects and we have to have them pretty fast. Unlike a tax cut which immediately gives a tax payer more money to spend, an infrastructure project has to be planned, approved, contracted, environmental regulations checked, and so on. Shovel ready projects are a joke. This spending could drag on long after my ashes are spread in Biscayne Bay.

And then there is the issue of where this infrastructure might be built. Since Harry Reid is a has-been it probably won’t be done in Nevada. Politicians will be in seventh heaven fighting for the next bridge, road, or waterway. What a glorious boondoggle!

And then even if some projects get started, what about the spending multiplier theory? The employment-spending-more employment-more spending theory assumes everything else is the same. In 2017 our nation is deep in debt. Our firms are not expanding. Perhaps construction workers will pocket some money, pay off some bills, and the story ends there.

And finally – tada – what about cause and effect? Is our slow growth these days really caused by potholes? I don’t think so. But one major thing many of us agree is that growth is very much impacted by slow labor supply growth, a mismatch of skills, and generally a poorly-functioning labor market. So why not focus on that? If that is the real problem then more IS is really what liberals usually call trickle down. Why wait years if not decades for an uncertain trickle? No prostate jokes please!

Instead we can use some or all of that IS money to improve our work situation. We could seriously fund training, retraining, and relocation. Rather than spiffy highways we could create the world’s employment champion. Wouldn't it be cool if global companies starting moving to America because we have the world's most outstanding employees for the 21st century?

We know that transition is a constant. If we know that renewables will take a larger share of national and world production, why not have the world’s best labor for that? If we know that the GIG economy is employing more and more millennials, then why not shout to the world that the best labor for that is right here in the USA? If Internet security is going to be a global challenge for the foreseeable future why don’t we have the best minds trained here? Healthcare? Entertainment? Whisky? (You didn't think I was going to leave out JD did you?)

If labor is the problem in this country then it ought to be solution. We need to stop wringing our hands and most of all – we need to stop thinking that the best we can do is use company subsidies to improve the labor market. Companies may or may not decide to spend a subsidy on labor.

And of course notice what there is no trickle down if we focus directly on the labor market. Helping people do better in the labor market has immediate impacts on their employability. It makes them more productive, competitive, and valuable. Perhaps we could call this trickle up economics since the benefits start with the workers and then radiate outward to more successful and competitive companies.

Finally when I say labor I don’t mean labor unions. A sincere focus on training, retraining, and relocation means we are strengthening workers for what they want – better pay, improved mobility, and more sustainable jobs and careers. Labor unions can get on board but this idea is not about enriching union bosses. Remember when we decided as a nation to put a man on the moon. We had a clear focus and we made it happen. America can be the training ground for a revolutionary new center of employment readiness. I'd rather see us spend a lot of money in that way than on infrastructure boondoggles. 

Fiscal Rock and Hard Place

The rock and the hard place has finally arrived. For those of you not familiar with this terminology, when you are between a rock and a hard place there are no easy or good options to solve your problem. Basically you have let things fester so long that all the reasonable solutions no longer exist. You have procrastinated so long that every solution left is painful.

We see this all the time. It is easy to put off a diet or an exercise program. A diet or exercise program is easy but also so easy to put off until later. But then when you get too heavy or too out of shape, even a small movement in the right direction is much tougher. Geez, do I really have to lose 100 pounds? Yikes. No way. If this seems silly then just read the most current news coming out of Brazil, Argentina, and Venezuela. The past governments spent all the money. Now they have only horrible options.

I wrote two weeks ago about monetary policy and how the Fed still continues to procrastinate about returning to a normal policy. Today’s post turns to fiscal policy. It focuses on how we deal with the fiscal rock and hard place. Basically it is to make believe – make believe that the rock and hard place does not exist.

How can I say that? Easy. I read the latest policy advice coming out of the OECD (Organization for Economic Cooperation and Development). The OECD is a world organization with 34 country members. The OECD studies and writes about the world economy and routinely makes forecasts and gives policy advice.

The latest words from the OECD are titled “Policymakers: Act now to keep promises” can be found at http://www.oecd.org/eco/economicoutlook.htp

I summarize but the main advice given by the OECD is (1) since interest rates are so low countries should enlarge fiscal deficits so as to increase aggregate demand, (2) structural policies should be used to increase productivity growth. Such policies include shifting fiscal policies to increase investment, encourage firm market entry, reform labor and product markets, and improve functioning of financial markets. (3) Avoid further monetary policies since they risk less effectiveness and more harmful side effects.

This advice is totally useless. The OECD must be doing this work on another planet. It flies in the face of what we know and basically proves that we are between a rock and a hard place.

     First, while we all know that monetary policy is now doing nothing but causing imbalances, most countries are fully engaged in almost exclusively relying on monetary policy. The OECD's monetary advice is correct but will fall on deaf ears. They know that so why give it?

     Second, as for using low and negative interest rates to finance further fiscal expansions this advice totally ignores the increased national debt loads in most countries. Sure it is nice to take advantage of low interest rates to borrow. But there are limits to prudent borrowing. Most countries have no room to borrow. This is horrible advice. 

     Finally, the most disingenuous of the policy advice given above has to do with structural reform. Most countries have totally rejected structural reforms because they are too political in nature. Take Paris right now. What self-respecting union is not on strike right now? The current government of France wanted a tiny little bit of labor market reform. Non merci. The best most of us can do is to argue that infrastructure spending is good structural reform. But please – this is just a flimsy excuse to increase debt. As we learned recently from shovel-ready projects  -- infrastructure spending might impact our national economic policies when your grandson becomes eligible for Social Security.

The OECD and others are correct to worry about but short- and medium term productivity and economic growth. But what they don’t want to tell us is that we have procrastinated so long that even sensible policy suggestions seem ludicrous. It won’t take anything creative or fancy to solve problems in most countries. But the politics are too ripe for any of that boring stuff to be supported. Now seems to be the time for impassioned speeches and exaggerated emotion. Make mashed potatoes illegal but never preach the virtues of simple everyday vegetables and modest portions! Get monetary policy back to normal. Get debt back to normal. Don’t throw  business under the bus. But alas, those policies will cause major and painful adjustments. On to snake oil.  

Guest Blogger Buck Klemkosky Slow and Steady Job Growth Not Enough

The U.S. Labor Department announced job growth of 215,000 for March in line with expectations. Given a working-age population of over 200 million, it doesn’t seem to be a significant number of jobs. But 215,000 new jobs are the net increase of many moving parts.

Annually, the U.S. creates a little less than 13 million jobs, but also destroys about 10 million jobs. If there was a net increase of 215,000, it means that approximately 1.05 million jobs were created and 833,000 destroyed for the net increase of 215,000 in March. Even during the Great Recession, 10 million jobs were created annually but unfortunately 16 million jobs were destroyed. In the U.S., job creation peaked out at 16 million in 2000 and hit 14 million in 2006, so the economy has not recovered in terms of job creation. Fortunately job destruction of 10 million is a three-decade low.

Since the labor market hit bottom in February 2010, a net of 14.4 million jobs have been created over the 73 months, a record for the longest period of sustainable job growth. The unemployment rate rose to 5.0% in March from 4.9% in February. As perverse as it may sound, the rise in the unemployment rate was considered good news because the civilian labor force participation rate increased to 63% from a 39-year low of 62.4% in September, meaning more people are entering the work force. The labor participation rate of workers ages 25-54 was 81.2% in the first quarter, a three-year high, but still down from 83.3% in 2007. There still is some slack in the labor market.

The mood of many Americans doesn’t reflect the lowest unemployment rate in nearly a decade. While a net 14.4 million jobs have been created, only 5.6 million new jobs have been created since January 2008, which was the job peak before the Great Recession of 2008-2009. Job growth relative to population growth makes the 14.4 million look less impressive. The U.S. working-age population grew by 15.8 million since 2010 and 20 million since 2008. Job creation has not kept up with population growth. The Labor Department also reported that average hourly earnings increased 2.25% in March, relative to a year ago. This is below the last 6-month average of 2.5% but better than the 2.0% annual average over the prior four years.

Wages are subdued primarily because labor productivity remains close to zero. Productivity is weak because corporations have not invested in efficiency-enhancing equipment and may be substituting labor for capital because of low wages. Also the cause of the productivity problem may be structural; the service sector of the economy has become more dominant relative to the goods sector, and it is more difficult to increase productivity in the service sector. Also, less experienced millennials are replacing more experienced baby boomers in the work force.

Regardless of stimulative monetary and fiscal policies, the key to enhancing economic growth lies in the labor market. Economic output is a function of the number of workers times the productivity of each worker. The civilian labor participation rate needs to continue on its upward trajectory and labor productivity must improve. Increases in both are needed to get U.S. economic growth out of its lethargic 2.1% pace. Labor-force growth of 2% and productivity increases of 1% would produce a more desired 3% economic growth.

Lesson 3 Productivity: Not Such a Mystery

Alan S. Blinder wrote an article a couple of weeks ago in the Wall Street Journal called “The Mystery of Declining Productivity Growth ” (May 15). Who doesn’t like a good mystery? So I picked up the article and started looking for who killed Cock Productivity.  And then it hit me. This could be Lesson 3. All of you HomeEc majors are going to love this one.

Now that you have GDP under your garter belt it is now time to master another macro indicator, productivity. And it is a good one to master. Productivity is important, misunderstood, and controversial. And because productivity is the result of dividing two numbers, it is arithmetically challenging.

Productivity is important because it is a key driver of a nation’s output growth. We all have t-shirts that say Go Growth because we have fallen prey to this macro mantra. Recall that GDP is like a mountain of stuff. We like the mountain to get bigger each year. Macro says it gets bigger each year if we have one or more of the following:

            More labor producing stuff

            More capital (plant, equipment, software, etc) producing stuff

            More Productivity (Better ways of producing so that using a given amount of labor and capital gives you even more stuff)

Productivity is misunderstood. First, it is defined as output per unit of labor input. (Note: for those of you who know the difference between a two-factor and a one-factor production function please ignore my using labor productivity rather than total factor productivity. It seems easier to discuss this topic using labor productivity. I realize that technically it is not correct. But it does no harm for my purposes here).

To calculate productivity you therefore have to divide output by the number of labor inputs. People love rising productivity as much as a grilled cheese sandwich on white bread. Suppose Lila goes to a yoga camp and comes back to the factory all stretchy and happy. Her experience at that yoga camp means that Lila can now produce 10 Nehru jackets each day instead of her former best output of 7. She is still just 1 worker – but now her productivity is 10 instead of 7.  Her boss, Mohammed, is quite happy with this result. Getting more work out of Lila and paying her the same means Mohammed can afford more chicken wings and wheat beer at the Upland Brewery on Friday night. Of course, since Lila can produce so much more in a given day, Mohammed has other choices – he can reduce the price of his Nehru Jackets and/or give Lila a pay raise.

Do you see why we like productivity to increase? Workers who become more productive lead to higher output, higher profits, higher wages, and lower prices. Slower growth or lower growth of productivity is not good and leads to the opposite. So companies and countries try very hard to improve worker productivity.

Rising productivity is good but it is pretty complicated. A second reason for misunderstanding is that if Lila can produce so much, maybe old Mohammed can fire Adore, her co-worker who has been known to read Herman Hesse novels on the production line. That doesn’t sound so good. Higher productivity can lead to a reduction in employment. Some of you are old enough to recall when the tractor replaced the horse.  A lot of horses and agricultural workers got replaced when tractors increased the productivity of Ag workers – the ones who could master those new-fangled tractors.

Like Hillary Clinton therefore, productivity has a checkered past. This leads to controversy. One controversy has to do with the question of employment. Some productivity gains are very bad for some workers who get displaced by the new technology. But recall – stronger productivity also means more output, increased competitiveness, higher wages and so on.  The higher output can lead to more employment. A new technology causes an initial employment decline and it may take years before the output effects generate more employment. So it is a tough call for politicians to actively promote increased productivity – even though it is the key way to increase GDP for the future.

Okay we are almost done and it is getting close to 5 PM and I can hear JD screaming for me. Here is where we get to the mystery, whodunit, and then the solution. Alan Blinder notes that productivity growth slowed in the USA since 2005. It is barely crawling at 1.3% per year compared to a rate of 2.9% before that. You used to be able to dunk the basketball. Now you can barely touch the bottom of the net using a trampoline. This is a serious decline.

Blinder in his Alan Blinder sort of way says this is both a problem and a mystery. We should solve this mystery. But in my humble opinion Prof Blinder may have been spending a little too much time lately in Colorado and Washington State. He lays off this mystery to things like getting free services off the Internet and how much of the current tech boom (Facebook, Twitter, Snapchat) creates employment but not much output. He also says that businesses are churning less and that means less output from entrepreneurs.

There might be some truth to Blinder’s story but being one of the liberal persuasion it seems that Blinder simply does not want to admit to a whole other set of factors that might be important enough to have cut productivity growth by more than half. These items are not a mystery. Two recent articles offer a totally different view from Blinder– and suggest that the mystery is not very mysterious.

Martin Feldstein writes “US Underestimates Growth” (WSJ 5/19/15) and concludes that measurement problems during a time of rapid technological change underestimate GDP. The output and productivity are there – it is just that the government’s methods to measure them are not flexible enough. Feldstein goes on to say that approaching the productivity problem needs to address why firms are not buying more capital, why workers are not joining the labor force, and why smaller firms are not innovating. His advice is to focus on reducing tax disincentives and reforming taxes so firms want to invest and workers want to work. This,of course, is basic supply-side economics.

Dan Mitchell’s conclusion is pretty obvious from his title. “Big Government Is an Anchor on America’s Economy, Undermining Investment and Wage Growth” (WSJ May 16, 2015). Mitchell focuses on the thousands of new regulations imposed on financial, banking, and other firms in the years since 2008. These regulations create additional costs and uncertainty that prevent firms from expanding more and from workers actively seeking employment. 

Feldstein and Mitchell emphasize productivity problems that seem pretty obvious. I am not sure why Blinder sees this slowdown as such a mystery. Maybe his ideology does not include supply-side solutions and this we are left with mystery. I wonder what Sherlock Holmes would say about all this. 

Is Inflation like Cooking with Gas?

Cartoon by Jim Gibson

If you ever want to be really popular at a cocktail party or a high school swim meet, just drop the term “unit labor costs”. I jest but now I have your undivided attention at least until you get a text from your local pizza delivery service.

I would not say that unit labor costs (ULC) are the key to world peace or eternal personal salvation but I would claim that ULC is the least known and most helpful economic indicator for understanding the economy and especially what will come in the way of future inflation. Most of us are riveted now to stories about the Fed and I will not discount the fact that Fed policy is critically important to future economic growth and inflation. But let’s face facts, even if her majesty Hillary Clinton were to become the next Fed chair, we would still be stuck with ULC and she would have very little to do with that. What I show below is that sub-par inflation today is the result of two labor market factors – the rate of labor usage and wage increases. If these are temporary aberrations that disappear as we exit a very slow growth period, then we should be worried about inflation. But if longer term forces are at work in the US labor markets, then inflation could remain tame for some time despite massive monetary overhang.  

Most of us have learnt well that inflation is all about too many dollars chasing too few goods. Many of us have tattoos that say as much. Since the Fed is in charge of how many dollars rain down on the economy we usually associate inflation with Fed policy and how that policy affects our decisions to spend and/or save. The typical story is that the Fed injects money into the system, thereby reducing market interest rates, resulting in flash mobs at your local car and real estate companies.  All that new demand for goods and services, according to this tale, stimulates Charlie Sheen and others to buy stuff and this increases output, employment and prices.   It is a demand-side story and it is told over and over and over in our universities and art galleries.

I am not writing today to deny that story though if you will look at my thousands of past posts, you will find plenty of ammo that suggests some inconsistencies in that theory. But today is instead about why that story isn’t enough. It is a nice macro/market story but it doesn’t really get into the nitty gritty of price setting. Price setting is done by firms. Companies do not change their prices randomly and in the US most firms do not get a note from the government telling them what price to charge today. Clearly the demand for a company’s goods is important to the price setting decision but much also depends on internal production issues.

Economists believe that companies either seek profits or market share when it comes to pricing. When demand increases that will get their attention. But will meeting that extra demand mean a larger profit? To know if more production will generate larger profits the firm has to answer two questions – how productive is the labor input? and how much will the extra labor cost?

Unless a company has excess labor sitting around eating handfuls of chips loaded with onion dip, a sizable permanent increase in output usually entails more workers or more worker hours. Suppose there is a demand for 100 more units of chicken noodle soup. If in one company the workers are not very productive but they are expensive, that company might not make much money by meeting the extra demand. In another company the workers are highly productive but not as expensive then that company might expect higher profits from meeting the extra demand. Depending on the productivity and labor costs either company might want to raises prices to bring in even more profits – but that might come at the expense of market share.

The point is that a demand change is not sufficient to predict changes in employment, output, or price. We also need information on what is happening to productivity and compensation costs. Which gets me to today’s topic. Despite the Fed and despite record attempts at stimulating demand in this country, we have not seen much inflation. The table below helps us see why we have seen lackluster inflation and gives us some pointers when it comes to thinking about the future and what might happen to inflation once we distance ourselves from the world recession.

I compare the last five years (2007 to 2012) of recovery from the recession (first column of the table below) to a similar period in the previous five years (2002 to 2007, last column). Using two different measures of inflation (based on the GDP price deflator and the CPI) it is clear that the last five years has shown a marked decline in inflation. Inflation has been growing at a little more than half of the previous period. We see this behavior has a lot to do with ULC. ULC measures the cost-side. It tells you how much more it COSTS to produce an additional unit of output. Firms didn’t need to raise prices much in the second period because their costs per unit of output were barely rising. Whereas ULC grew at more than 8% before 2007, they grew at just a little over 1% since 2007. That  is a remarkable change in the cost of producing an additional unit of output.

The table helps us to understand why business costs have been rising so slowly. Notice that in the last five years, labor compensation rose by 11.2%. That is half the rate of the previous five years when compensation increased by 22.2% rate. Productivity, in contrast, could not keep up the former pace of almost 13% but did manage to grow by nearly 10%. The decline in productivity growth means added costs of production but this upward impact on costs was swamped by the rapid deceleration of labor compensation.

The productivity part of the story is interesting. The decline in productivity had two major sources. First, total output of firms grew by only 3.9% in the past five years – much slower than the 18.4% in the previous five years. Equally dramatic was the reduction in labor hours – which showed a decline of 5.3% in five years. Firms were using fewer labor hours in 2012 than they did in 2007. Productivity has grown recently because firms have dramatically cut back on employment and hours worked.

We summarize all this as follows:

• Inflation is lower because costs per unit of production are growing more slowly.
• Costs per unit are growing more slowly because wage and non-wage compensation have slowed and because firms have cut back on employment.

The US economy is growing and output is rising albeit at a modest pace. The usual situation is that once the economy’s growth returns to something more normal, compensation growth will accelerate and employment will expand. This natural progression implies that productivity growth will decline, ULC changes will increase, and inflation will rise. It’s like microwave popcorn. Put the bag in the microwave, set the timer to 3 minutes, remove the bag when the popping stops, open the bag and add a little salt. Then eat. It’s like cooking with gas.

But is inflation like cooking with gas? Is it going to come back when economic growth resumes? Or will longer-term factors impede the usual employment, wage, and benefits progressions? What do you think?

                              Table: Percentage Changes

      2002-2007              2007-2012

Hours                            4.5                        -5.3

Output                         18.4                         3.9

Productivity                  12.7                         9.7

Compensation/Hour      22.2                       11.2

Unit Labor Costs            8.4                          1.4

Unit Non-Labor costs   17.3                        14.8

Inflation (GDP deflator) 11.9                          6.8

Inflation (CPI)               15.2                        10.8

Sources:  http://www.bls.gov/news.release/prod2.t06.htm

ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt

US Competitiveness and Charlie the Tuna

Charlie the Tuna was a figure in a Starkist commercial many years ago (circa 1961). Charlie confused tuna’s with good taste (culturally adept) with those that taste good. Anyway, we affectionately nicknamed one of our childhood friends Charlie the Tuna. Charlie is a regular reader of this blog and generally lambasts me about my negative attitude toward US manufacturing. Charlie is a devoted cheerleader for US manufacturing and he should have been proud when the US announced productivity figures this week.  More will be said about US productivity below.

But first, let’s discuss US competitiveness. While the “C-word” can probably mean different things to different people, we often associate national competitiveness with an ability of a given country’s products and services or its firms to duke-it-out with firms from other countries. China’s export success is often taken as evidence of that country’s increased competitiveness.  Persistent and growing trade deficits of the US are considered to be evidence of the opposite.

Competitiveness in the above sense can be affected by many things. For example, the US often argues that China unfairly depreciates its currency or gives unfair subsidies to its firms as a means to improve competitiveness. Of course, fundamental factors are also important, factors that relate to the ability of a nation’s firms to produce high quality and innovative goods at the lowest possible prices.  That is where the recent announcement of the Bureau of Labor Services (BLS.gov) comes in.  On May 5, 2011 a news release announced data for productivity and costs for Q1 2011. While this was ignored by most outlets that cater to normal people, Bloomberg had a story titled something like “Productivity advanced by a measly 1.6% while business costs increased in the first quarter of 2011.” Even that headline failed to be as interesting as other stories nearby like “Babies who stop bottle feeding at one year are prone to be really fat” and “Physicists at the University of Alabama uncovered a bio-marker for athlete’s foot.”

If you actually read the government press release you understand why this critical information essentially gets blown in a black hole in some distant universe.  I read it and found myself quickly adrift with sea nymphs and cheerleaders.  After my nap I decided to go to the BLS website and see if I could discern a story from the actual data and sure enough it was all there. There is a story and it basically says a couple of things. First, Charlie the Tuna should be very proud since manufacturing is clearly leading us out of the wilderness. Second, the numbers suggest that the government has to STOP stimulating the economy. If there is any way to improve US competitiveness, it is by keeping inflation low and government debt in control. Since neither of these points is obvious on their own merits, let me try to convince you they are true.

The first bit of data in the release is something called UNIT LABOR COSTS. This is like naming your kid Ora. No kid wants to be called Ora. No economic variable wants to be called Unit Labor Costs. So let’s just rename it ULC. ULC is a measure of how much labor cost is changing in a typical unit of output.  If ULC change is zero, it means that labor involved with producing, e.g. bagels, are not causing change in the cost of producing one bagel.  If ULC for bagels is increasing by say 10% that tells us that labor costs are responsible for a 10% increase in costs of making a bagel. Companies become better competitors when their ULC is slowing – or better yet, decreasing. So ULC is an important aspect of a company or a country’s competitiveness.

After increasing at a rate of about 1.8% per year from 2003 to 2007 ULC of the non-farm business sector increased by only about 0.3% in 2008 and 2009 and then declined by about 0.2% afterward. The experience of manufacturing companies was very different. During the strong growth period from 2003 to 2007, ULC grew by only about 0.2% per year. During the recession ULC grew at an annual rate of almost 5% only to decline again in the recovery quarters to -3.6% per year. While the experiences were different the outcome for the last seven quarters is the same – manufacturing and other non-farm businesses have seen ULC decline.

One conclusion is that the US is experiencing improved business competitiveness in the recovery period – and this improvement has been especially strong in the manufacturing sectors. What explains this? The most straightforward answer comes from the definition or calculation of ULC. There are two key factors that determine changes in ULC: labor compensation per hour and labor productivity per hour. Recall that ULC has to do with labor costs embodied in the average unit of output. So clearly, a change in labor compensation per hour will impact ULC. If the Bagel Workers of America obtain a 10% per hour wage increase and if they work the same number of hours you can see how this will raise business costs and ULC.

But how much ULC increases depends on productivity change – or what we call output per labor hour. Let’s suppose workers get 10% more wages per hour but also are able to produce 10% more output per hour? Total costs would rise – but the costs per unit of output would not. So now you see that both output per hour and wages per hour must be brought together to understand ULC.  And we learn the following:

o   Wages per hour growing faster than output per hour --- ULC rises
o   Wages per hour growing slower than output per hour --- ULC falls
o   Wages per hour growing the same as output per hour --- ULC constant

In the expansion years from 2003 to 2007, manufacturing compensation per hour was rising at about 3.5% per year. But output per hour was growing by 3.7% per year so ULC hardly grew at all.

When the recession hit in 2008 manufacturing compensation actually increased to an average annual rate of about 4.8% per. Productivity declined at a rate of -0.4% per year and therefore ULC was rising at about 5.2% per year.  While rising wages contributed to ULC rising it was the decline in output per hour that really hurt competitiveness.

Coming out of the recession in 2010 (Technically the recovery begins in the third quarter of 2009) and early 2011 manufacturing productivity recovered dramatically averaging about 6% per year. Wages per hour have slowed to a rate of a little over 2%. Thus coming out of the recession ULC is falling at a rate of about -3.6%. Of course, this is exactly what you want to see if the US is going to grow through exports. Moreover, this enhanced competitiveness gives firms the ability to provide more goods at low prices within the US – improving both national output and inflation.

The following table summarizes the key numbers discussed above.

                                                Average Annual Percentage Change

                                                Manufacturing companies

                    Compensation       Output                     ULC

                          per hour               per hour

2003 to 2007       3.5                      3.7                        -0.2

2008 to 2009       4.8                     -0.4                         5.2

2010 to 2011       2.5                      6.1                        -3.6

So what does this mean for policy? First, the usual business cycle factors will mean that compensation will probably soon increase by more than 2.5% per year and productivity will not continue rising at 6% per year. Thus ULC will probably increase.  The role of policy, then, is to slow this normal cyclical process as much as possible in two ways: (1) provide an economic climate such that wage growth does not quickly rise and (2) ensure that output per hour does not quickly decrease.

Here is where the stimulus and national debt come in. Monetary and fiscal stimulus raises inflation expectations. The Treasury and the Fed keep reminding us that inflation is subdued. But it won’t be forever. Signs of inflation are around us everywhere. If we want competitiveness and manageable ULC, then we have to effectively and credibly convey a strong disdain for inflation. If workers do not believe that stimulus will be removed in a timely manner then they will quickly and decisively pursue faster wage growth.  I buttress this forecast by looking at the real value of hourly compensation. Since 2002 the buying power of the hourly compensation in manufacturing companies has grown by less than 1% per year. While manufacturing workers during those years got hourly wage increases – they were barely enough to meet inflation. They are more than ready to make up for lost time.

But wages and inflation are only part of the story. The rest concerns productivity or output per hour. To maintain competitiveness, US firms must continue to invest in new equipment, structures, training, etc. To do that they need abundant and well priced capital. With government finance sucking up more money than US households can supply from their meager savings, this reduces the pool of available resources and significantly raises interest rates and the cost of capital. Any further indications that the US will not be able to pay its obligations will lead to a hasty departure of foreign funds and even higher costs of borrowing and/or raising capital.

Quick progress to reduce deficits and national debt will go a long way to improving productivity, the cost of labor, ULC, and US competitiveness. You would think that our goofs in government would come to understand this and stop playing with ideological bombs and class warfare.  The below chart shows (found at (http://research.stlouisfed.org/fredgraph.png?g=pj ) how important manufacturing ULC is to the health of the US economy. Notice how significant upward trends in ULC led to recessions after 1990 and 2000. While ULC was well-behaved before the last recession we all know the important role of finance in that one. But also notice that the recent recession has left us with historically high ULC. Despite recent improvement it is clear that ULC has a long way to go before it reaches more normal levels. Until then our competitiveness AND our national economic growth are in jeopardy.

Note – if you cannot see the below graph properly, please try the above link.